LONDON (Dow Jones)--The volume's rising in the fight between Warner Music Group and EMI, as both have now rejected bids for each other. But the Americans have an edge over the British.
Given Warner Music's track record and balance sheet strength, it has the stronger bidding hand - and is likely to do a better job in integrating the two businesses than EMI.
WMG's 320 pence a share offer values EMI at 12X its EBITDA. EMI's bid for WMG is at a higher multiple, but since on the basis of various indicators WMG's a stronger company some of the valuation differentiation is justified.
WMG's relative strengths over EMI are also reflected in their share price movements in the past year, with WMG's shares outperforming EMI by nearly 40%, according to Datastream.
Both companies have gone through challenging times of late but WMG, led by Edgar Bronfman and his private equity backers, have done a better job in responding to the sector's changes.
WMG bit the bullet when the music industry slowed post-2000, cutting relatively more costs than EMI and cleaning up its balance sheet faster. WMG's operating improvements have translated into more operating cashflow than over at EMI.
To wit, EMI's sales rose 7.1% from 2005 to 2006 but its operating cash flow fell 11.3% to $150 million. The culprit: poor working capital management. However, the company's share purchases continued and it kept its dividend payout steady. The company also maintained its capex.
EMI's aim has been to retain investor interest by returning capital, at the cost of long term growth. It dipped into its own cash reserves, without improving its leverage.
At the end of its 2005-2006 fiscal year, 60% of EMI's assets were debt-financed, while for WMG the figure was 50%. Even from a profitability point of view, EMI's gross income margin stands at 38.4%, below WMG's 42%.
Indeed, WMG has been more effective in using its assets in the last five years. Over this period sales rose slightly, by 0.24%, while EMI's fell 4.9%.
EMI's weaker operating and financial base does not allow it to do a string-free deal. It will have to sell its Warner Chappell Publishing unit - and has said it will do so - for potential 14X or 15X EBITDA multiple to collect $2.2 billion to partially finance buying WMG.
Indeed, given that the global music industry is showing early signs of turning around, in part on the back of digital sales, it's natural for EMI shareholders to be reluctant to give in just yet.
That means WMG needs to sit down with EMI and offer part of the consideration in WMG paper to allow its target shareholders to participate in the upside. Some of the earnings dilution will be outweighed by cost savings which can be had from distribution, label and artist consolidation.
If Arcelor and Mittal Steel's managements - with different language and cultural backgrounds - can swallow their pride and seal a deal, surely EMI and WMG can work out a combination that benefits both.
After all, WMG is big in the U.S. while EMI is big on this side of the Atlantic - and both need each other's markets.
(Arindam Nag has covered business and finance for 15 years in Asia, Europe and the United States. He can be reached at +44 207-842-9289 or by e-mail: email@example.com)